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Executives

James L. Wainscott - Chairman, President, and CEO

Albert E. Ferrara Jr. - VP, Finance and CFO

John F. Kaloski - Sr. VP of Operations

Analysts

Brett Levy - Jefferies & Company

David Martin - Deutsche Bank

Charles Bradford - Bradford Research

Bob Richard - Longbow Research

Michelle Applebaum - Michelle Applebaum Research

Evan Kurtz - Morgan Stanley

Michael Gambardella - J.P. Morgan

AK Steel (AKS) Q2 FY08 Earnings Call July 22, 2008 11:00 AM ET

Operator

Good morning, ladies and gentlemen and welcome to the AK Steel Second Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].

As a reminder, this conference call is being recorded. With us today are Mr. James L. Wainscott, Chairman, President and Chief Executive Officer of AK Steel, and Mr. Albert E. Ferrara Jr., Vice President of Finance and Chief Financial Officer. At this time, I would like to turn the conference call over to Mr. Ferrara. Please go ahead, sir.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Thank you, Peggy and good morning everyone. Welcome to AK Steel's second quarter 2008 conference call and webcast. In a moment, I will review our second quarter 2008 financial results as well as provide some data points and guidance for our third quarter. Following my remarks, Jim Wainscott. our Chairman, President and Chief Executive Officer will offer his comments and field your questions. I would like to remind you that today's conference call includes certain forward-looking guidance for 2008. Other than our comments on historical results, the remarks we make today constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934.

These statements include our expectations as to our future shipments, product mix, prices, costs, operating profit, and liquidity. While we believe that our expectations are reasonable, we cannot assure you they will prove to have been correct, since they are based on assumptions and estimates that are inherently subject to risks. Such risks include economic, competitive and operational risks, uncertainties and contingencies, all of which are beyond our control and based upon assumptions with respect to future business decisions that are subject to change. Except as required by law, the company disclaims any obligation to update any forward-looking statements to reflect future developments or events.

For more detailed information, we encourage you to review the discussion of risks affecting forward-looking statements found in the management's discussion and analysis section of our Annual Report on Form 10-K for the year ended December 31, 2007 as updated in our most recent quarterly report on Form 10-Q. Also to the extent we refer to material information that includes non-GAAP financial measures, the reconciliation information required by Regulation G is contained in our news release that was issued earlier today and is available on our website at aksteel.com.

Earlier today, AK Steel reported second quarter 2008 net income of $145.2 million or $1.29 per diluted share. The results represent a 44% improvement over our first quarter 2008 net income of $101.1 million or $0.90 per diluted share. This performance represents AK Steel's best quarterly earnings from continuing operations since the company's executive management changes in the fall of 2003. During the second quarter of 2008, we achieved record shipments of 1,737,800 tonnes, which was approximately 159,000 tonnes higher than our shipments for the first quarter.

Second quarter 2008 revenues were a record $2.24 billion, a 25% increase over our first quarter 2008 revenues. Our second quarter revenues were driven by record quarterly average selling price of $1,287 per ton. This was an increase of $152 per ton or approximately 13% compared to the previous quarter's average selling price.

Our quarterly average selling price improved in the second quarter due to several factors including higher contract and spot market pricing and increased raw material surcharges. AK Steel's ability to access global markets was also a benefit in the second quarter. Our non-US revenues increased by 52% over the second quarter of 2007 to $349 million or 16% of total sales, clear evidence of AK Steel's expanding global footprints. The increase was due to strong worldwide demand for certain of our products especially our high value added electrical steels. AK Steel's business model allows us to focus on products and markets to improve profitability.

On the cost front, we continued to be negatively impacted during the second quarter by an unprecedented level of higher cost for raw materials and energy. The higher raw material costs were a major factor in driving our second quarter LIFO charge to approximately $143 million or about $82 per ton, which was much higher than we had anticipated in our guidance for the quarter. As we indicated in our April 2008 conference call, planned maintenance outage cost during the second quarter were $41 million primarily due to the work we completed on the blast furnace at Middletown Works. Netting quarterly revenues against cost, we generated record operating profit of $237.9 million or $137 per ton for the second quarter of 2008. Our second quarter operating profit continues our string of triple-digit quarterly operating profit per ton performances.

Moving from earnings to cash, we ended the second quarter of 2008 with a cash position of $381 million, representing an increase of $109 million from the end of the first quarter. We increased our cash level during the quarter, while continuing to reinvest in the company and strengthen the balance sheet. For example during the second quarter, we made capital investments of approximately $50 million and made another early pension contribution of 75 million, which satisfies our 2008 funding obligations.

As we have discussed in the past, we also continue to place a high priority on the management of our working capital. We are pleased that working capital generated about $21.5 million of cash during the second quarter, that's especially significant considering the higher sales levels and increased raw material prices that we continue to experience.

Our focus on controlling working capital also helped grow total liquidity to a solid $1.1 billion at the end of the second quarter. We expect to continue to generate strong cash flows during the second half of 2008, which will provide us with solid liquidity and financial flexibility throughout the remainder of the year.

Now let's take a brief look at our results for the first half of 2008. Revenues for the first half were a record $4 billion compared to revenues of $3.6 billion in the first half of 2007. Our non-US revenues of $593 million represented approximately 15% of our total sales for the first six months of 2008, an increase of roughly 38% over the first six months of 2007.

Our operating profit for the first half of 2008 was $407.6 million or $123 per ton. Excluding pre-tax, non-cash pension curtailment charges of $39.8 million related to labor agreements at our Mansfield and Middletown plants, our operating profit for the first half of 2007 was $347.2 million or $105 per ton. Net income was $246.3 million for the first half of 2008 or $2.19 per diluted share. Net income for the same period of 2007 was $172.6 million or $1.55 per diluted share.

With that recap of our second quarter and first half performances, let me now provide you with some guidance for the third quarter. We expect third quarter shipments of approximately 1,550,000 tonnes, a decrease of approximately 1,88,000 tonnes from our record shipments in the second quarter. On the pricing front, we expect third quarter average selling prices to be approximately 10% or $130 per ton higher than our record average selling price achieved in the second quarter.

Relative to our cost, we expect continued increases in raw material and energy, particularly for carbon scrap, chrome scrap, iron ore and natural gas. We estimate these cost increases to equal approximately $100 per ton above second quarter levels. As was the case in the second quarter, we expect to incur substantial LIFO charge in the third quarter of 2008.

During the third quarter, we anticipate maintenance outage cost of approximately $10 million, which is about $30 million lower than we experienced in the second quarter. We expect a lower cost despite a planned 5-day outage at the Middletown Works hot-strip mill. All things considered, we anticipate generating a third quarter operating profit of approximately $170 to $175 per ton, comfortably exceeding the record operating profit per ton we achieved in the second quarter.

Now for his comments, here is Jim Wainscott, AK Steel's Chairman, President and CEO. Jim?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thank you very much, Al. Good morning everyone and thank you for joining us on today's conference call. We're delighted to have you with us as we discuss another quarter of record setting results for AK Steel. Above expectation, shipments and pricing in the second quarter coupled with continued solid cost performance enabled us to deliver record-setting financial results. We are proud to report that our operating profit of $137 a ton for Q2 ranks as the highest of any quarter in the company's history. I applaud these results or the people who made them possible, the men and women of AK Steel. Despite the challenges we faced in certain economic sectors and the dramatically higher steel-making input costs that we incurred, I'm quite pleased that we excelled in the controllable facets of our business. And I want to salute our Board of Directors and our senior management team for their vision and leadership in helping us get to this new level of success.

Let me take just a moment or two to add a little color commentary to some of those challenges that we faced in the second quarter, starting with a couple of comments on our largest contract market, automotive. There is no sugar coating at the present automotive situation, it's pretty dismal and to put it into perspective, compared to the year-ago sales level, June 2008 US light vehicle sales were down by more than 18% and first half 2008 automotive sales were at their lowest level since 1993.

With concerns about high gas and oil prices, 56% of vehicles sold in the month of June were in the passenger car category and that represents a big shift from sales of more steel intensive trucks, mini vans, and SUVs in recent years. But as the markets have changed so has AK Steel and under the circumstances, I believe that we have adapted pretty well. For example 40% of our 2007 total annual sales were derived from the automotive market. For the second quarter of 2008, our automotive market sales were only 29% of total quarterly revenues. This represents our lowest level of automotive sales in more than a decade. Not surprisingly, our appliance market shipments and revenues were also depressed as the housing market slump lingers.

Offsetting these market declines, we have increased sales to spot market customers and as Al mentioned, we have substantially grown our export sales. Last week in response to increasing global demand for carbon steel products we announced a spot market price increase of $50 per ton effective with new orders scheduled for delivery on September 1 or later. We certainly felt the pain of high steel making input costs which rose significantly during the quarter for certain items such as coal, coke, iron ore, scrap, and purchased slabs, we experienced the highest cost in our history. And to those challenges, the blast furnace maintenance outage that cost us about $41 million and a much higher than anticipated LIFO charge and I suppose one could have made a real case for a bear of the second quarter for AK Steel. But the opposite is true. Despite the odds and adversity, I'm happy to report that the bull not the bear prevailed as we found a way to win once again. How did we do it?

In short, we continued to forge ahead by focusing on the fundamentals of our business, safety, quality and productivity. In my opinion, if you do these key things well and if you treat your customers the way you want to be treated, all things are possible and that was certainly the case with our second quarter performance. In terms of safety at AK Steel, safety is our highest priority, those are not just words, they are really a way of life around here because nothing is more important to us than the safety and health of our employees. In terms of OSHA, recordable injuries are too good at our plants as well as our steel plants located in Coshocton, Zanesville, Ashland and Rockport worked the entire second quarter of 2008 with zero recordable injuries. That's great work.

Of course, this is nothing new for our Rockport Works. On the fourth of July, Rockport surpassed six years without experiencing a single loss time injury. That's truly remarkable and rock steady performance at Rockport Works. Importantly, our quality performance continues to shine in the eyes of those whose opinion matters most, our customers. The latest Jacobson independent customer satisfaction survey showed AK Steel continuing to occupy its first place position in product quality. Great quality goes a long way towards reducing our company's operating costs, as well as improving the yields for our customers and thereby reducing their operating costs as well. During the quarter, we [inaudible] to receive the Outstanding Supplier Award from Impact Steel Canada, an important customer. The award was presented to us for outstanding customer support, quality and delivery.

In addition, our company continued to be ranked number one in overall customer satisfaction versus our competitors according to the Jacobson survey. That by the way is exactly where we want to be and where we intend to stay. And on the productivity front, we set a number of production records in the second quarter at our Butler, Zanesville, Coshocton and Ashland locations. We also came through our planned Middletown Works blast furnace outage in very fine shape which positions us well to meet our customers' future requirements.

Speaking of our customers and our customer relationships, let me offer some insight on this topic which has received a fair amount of press lately. I also want to emphasize that my comments are specific to AK Steel's relationships with its customers. While we read about unilateral surcharges that have been suggested or perhaps implemented by our competitors, we have no basis for knowing what our competitors' contracts allow or do not allow. But we certainly do know something about our agreements and our relationships with our customers and that's what I'd like to address.

We've spent the past five years rebuilding old and establishing new relationships with our customers. Frankly, without customers, the value of our business or any business is zero. We get that at AK Steel. Taken as a whole, I believe that our customer relationships are second to none, and I want to commend our sales force for its leadership in making that happen.

A couple of years ago, in light of escalating steel-making input costs, AK Steel began negotiating variable pricing mechanisms of one sort or another into its contract sales agreements and today, the vast majority of those agreements contain variable components of [inaudible] price adjustments, and those adjustments can move either up or down.

Accordingly, selling prices can vary and have varied depending on the movement of various market price in the energy cost and/or raw material costs. Importantly, our contracts has been mutually agreed upon with our customers and for years, they have formed the basis of our contract business relationships. As a result, changes that we've have made to our contract pricing or changes that are provided for in our mutual agreed-upon contracts, they have not been unilaterally imposed.

The bottom line is this. AK Steel honors its sales agreements, our relationships are based on trust and confidence, a deal is a deal. So despite much higher than expected input costs for making and finishing steel or living up to our contract sales agreements. But most of those agreements I might add are for a 12-month duration and expire at various points throughout the course of the year. As such, as our existing sales contracts expire, we are negotiating new deals that incorporate higher base prices reflective of current global market conditions and more comprehensive variable surcharges that take into account the major components of our record steel-making input costs. Our position is that the days of pure fixed-price sales agreements for steel products are history. New agreements must take into account not only the factors of supply and demand for steel, but also the supply and demand for steel-making inputs.

To be clear, in the future, AK Steel cannot and will not bear all the risks of price moments for iron ore, coal, coke, natural gas, scrap, coating metals and on and on. Not only is it a bad business model but we simply cannot afford the risk of doing so. Consequently, as new contracts are negotiated, the surcharge formulas are being modified and expanded in light of the unprecedented costs that we are experiencing for steel-making input costs.

As a reminder, about one half of our 2008 shipments are under contract with the remaining one half of our shipments sold in this spot market. For the second quarter, these percentages were closer to 48% and 52% respectively. I believe that one of our companies strengths is our ability to adapt quickly to changing market conditions to optimize our sales portfolio. AK Steel's relatively smaller size and our flat management structure provide us with great flexibility in adjusting rapidly to changes in the marketplace.

In that regard, we're increasingly taking advantage of sales opportunities outside of the United States. As Al mentioned previously, we generated a record level of revenue on products sold outside the US in the second quarter and we expect another record for the third quarter. In light of strong global demand, strong foreign pricing and the weak US dollar, we expect export revenues to be a significantly positive contributor to AK Steel's results going forward. So not all of our eggs, if you will, are in one basket.

Our sales are not just in North America nor do we sell only carbon steel products, in fact AK Steel offers one of the most diversified flat-rolled product lines of any steel marker in the world. In other words, we're not solely dependent on the US economy nor are we entirely dependent on the strength of carbon steel products. In addition to offering some of the finest carbon steel products anywhere, we offer a wide variety of specialty steel products including a full line of stainless steels in the 300 series variety, 400 series as well as silicon alloy electrical steels that are in high demand around the world.

Speaking about electrical steels, I'm happy to report that we continue to make excellent progress on completing our foreign electrical steel expansion project in the past four years and just yesterday, we announced an add-on to that project, our Board of Directors has approved the expenditure of an additional $21 million for new equipment to install AK Steel's proprietary annealing technology to a second processing line. This will give us added capacity of our highest efficiency grade of electrical steel and importantly it will enhance our overall product mix flexibility. This enhancement and our fourth electrical steel expansion project are expected to be completed in late 2009.

While around the subject of electrical steel, let me also mention that we are well on our way towards ramping up contract negotiations for 2009 with our electrical steel customers. It's still too early to provide details except to say that in light of more global demand and supply for this product line, we have succeeded in negotiating meaningful price increases for next year's electrical steel business.

In addition to our investments to grow our electrical steel capacity, we're putting our cash to work by investing in projects to lower our raw materials and energy costs and improve our self-sufficiency. We're also putting our cash to work to further strengthen the balance sheet and to reward our shareholders, and along those lines, I'm happy to report that our Board of Directors has authorized another $75 million Early Pension Fund contribution to be made in the third quarter of this year. This latest pension contribution represents an advanced funding of a portion of our required 2009 amount and we try to continue to stay in front of our obligations before they come due. Notably, for all of our pensioners that brings the $834 million, the total pension contributions made since the beginning of 2005. In addition, we've declared another $0.05 per share dividend for the third quarter.

Sufficed to say that it's been an exciting and record setting first half of 2008 for AK Steel and its shareholders. In the first six months of this year, we generated more than $0.5 billion of EBITDA, more than $400 million of operating profit equal to $123 per ton, nearly a quarter of a $1 billion of net income translating into EPS of $2.19. And we are poised to deliver a better second half of 2008, as we position ourselves for an even brighter future. We've succeeded in overcoming enormous cost challenges in achieving first half 2008 records in terms of shipments revenues and net income. And we are pleased that recently some prestigious third parties have recognized the company's complete financial turnaround and rewarded our progress. In fact we're thrilled to have been added effective July 1 to the S&P 500 Index, joining the Standard & Poor's 500 Index is a proud milestone for our company and reflects our ongoing efforts to create shareholder value.

In addition, we are excited and honored to have been designated a world-class steel maker by World Steel Dynamics. We now join the ranks of some 30 leading steel makers around the globe that are considered best-in-class.

While we're very appreciative with the accolades for our recent performance, we're also mindful that relying on what we did yesterday will not get us to tomorrow. World-class steel makers continue to execute, continue to move forward and continue to reinvent themselves and that's exactly what we intend to do at AK Steel. Despite all the talk of near-term economic doom and gloom, we intend to forge ahead. Unlike our integrated steel competitors with expiring labor contracts next month, AK Steel has no labor contracts that expire this quarter, and we're well-positioned to deliver steel on an uninterrupted basis to our customers.

As evidenced by our guidance for the third quarter 2008, taking everything into account we expect to report another all-time best quarterly performance. Following our record second quarter operating profit of $137 per ton, we look forward to generating operating profit in the range of $170 to 175 per ton. And as I mentioned, this would represent another record performance for our company. So despite the obstacles that may be in our way we will continue to forge ahead. Indeed we're well positioned to continue to exceed the expectations of both our customers and our shareholders. Thank you for your attention, ladies and gentlemen. At this time, let's open the phone lines for your questions.

Question and Answer

Operator

Thank you, Mr. Wainscott. We will now begin the question-and-answer portion of our conference call. [Operator Instructions]. One moment please for the first question. Our first question comes from Brett Levy of Jefferies & Company.

Brett Levy - Jefferies & Company

It's an awesome quarter. Congrats again, Jim and Al. First off, and I think I have asked this before, have you got the ratings guys looking at potentially upgrading you, I mean 19 tonnes interest covered going to 25, starting to sound pretty investment grade?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

We have had an ongoing dialog with the rating agencies. We continue the discourse that we've had. We've indicated our displeasure, if you will, with the level of ratings but we will continue to have discussions with them, and hopefully we'll get some better news.

James L. Wainscott - Chairman, President, and Chief Executive Officer

In fact I hope Brett, that Al makes a trip up there to New York later this week.

Brett Levy - Jefferies & Company

Okay. The next one is, as you guys look a little bit further out, I mean, can you tell me a little bit about the Ohio project, I think it's MMKs, whether that's making... I know they have like air permits or talk a little bit about the traction of that one, talk about what you are hearing about ThyssenKrupp's plant down in Alabama and sort of the competitive threat that that might mean to you and what the time frame you're hearing there? Just sort of talk about some of the longer-term competitive threats?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Well, let us just [inaudible] the following. First off, with respect to MMK. We only know what we read... read rather, it's in the Rumor Mill. As far as TK is concerned, again they are building, they are coming obviously to America. I really continue to question the assumptions that would lead anyone to think there is a shortage of automotives field in this company, or country rather. Having said that, I've got really every confidence that we'll compete with any steel maker in the world given the level of playing field on all fronts, including steel making input cost trade laws and other factors. We have overcome every challenges you've seen that's been placed in front of us and we will continue to do that. We will do so by continuing to meet the needs of our customers better than anyone else. If you are the leading guy out there as we are in terms of quality delivering service, what's the incentive to jump ship. We really don't see it, we really don't see the need for the continued expansion. So... and that's the story, we think it will be very difficult to earn the cost of capital but sometimes it's not necessarily economics that drive these decisions. So we'll see as far as the one that's still in the Rumor stage, the other is going to be here probably in another two to three years.

Brett Levy - Jefferies & Company

All right. Last question and I'll get out of the queue is, anything you guys are looking at on the M&A front or are you basically going to try to grow organically at this point?

James L. Wainscott - Chairman, President, and Chief Executive Officer

I think it's fair to say that our Board continues to look out and ask what is in the best interest, the long-term interest of our shareholders, what can create value for the shareholders of AK Steel, not necessarily the shareholders of someone else. In that regard, we've continued to look at internal growth by and large breadth through profitable projects such as the electrical steel expansions. Through the number five VAS [ph] and the coke battery projects to improve our self-sufficiency and reduce cost through further balance sheet improvement and directly enhancing shareholder value, I think those will continue to be mainstream themes for us. But we're always mindful, we're always looking at, what else is out there that might enhance value further for our shareholders. So I think we are studying that, we're looking hard at what's there for us and more to follow.

Brett Levy - Jefferies & Company

Thanks, guys.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Thank you, Brett.

Operator

Our next question comes from Dave Martin of Deutsche Bank.

David Martin - Deutsche Bank

Yes, thank you. I wanted to first come back to your cost outlook for the third quarter which I didn't fully understand. I think Al, you mentioned an increase of $100 a ton and gave some details of where the cost increases would be seen, but can you give us that detail again and maybe a few more details on the magnitude of the increases for each of those items?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Well, the thing is, David, what we're looking at in the third quarter against second quarter, clearly scrap continues to be having impact on us. We see pellets being higher quarter to quarter as well as natural gas and chrome. All those factors we don't really dollarize those specifically, but if you aggregate those it's fairly easy to come up to $100 per ton in increased cost quarter-to-quarter.

David Martin - Deutsche Bank

And why would pellets be up quarter-over-quarter?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Well, what you have is, as you have the increase against the second quarter, we're still getting some of the benefits, some of the pellets we had in the first quarter that were lower priced from the prior year. We didn't get the full contract impact, we won't have the full contract impact until the third quarter.

David Martin - Deutsche Bank

Okay. And then secondly, on your comments about non-US business, can you give us some information or details on what of that would be non-electrical steels in the second quarter?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

I would just say that it's a really across the board, it's a variety of products, it's a carbon steel, stainless steel and it's electrical steel and we are talking about Canada, Mexico but increasingly overseas, Europe and other parts of the world as we capitalize on infrastructure growth. As you know particularly in the bricks if you will, those economies are growing anywhere from 8% to 12% and that's really what's been driving up the cost of these steel-making inputs and this is an opportunity for us to capitalize on that especially given the value of the dollar.

David Martin - Deutsche Bank

Okay. Thank you very much.

Operator

Our next question comes from Charles Bradford of Bradford Research.

Charles Bradford - Bradford Research

Good morning.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Good morning, Chuck.

Charles Bradford - Bradford Research

I would like to talk a bit about coking coal and the new coke plant, has the plant gotten its permit yet and is it still on schedule? And then --?

James L. Wainscott - Chairman, President, and Chief Executive Officer

I'm sorry, go ahead.

Charles Bradford - Bradford Research

And then, does the capital cost of the plant include the electric generation capacity that is supposed to be attached?

James L. Wainscott - Chairman, President, and Chief Executive Officer

First off, in terms of the timing, we are on schedule still, we have... we are anticipating getting our permit the next month or two and that will keep us roughly where we need to be for a late 2009, startup. There have been a couple of detailed issues with respect to the local zoning process that we're largely through and pressing ahead in that regard. So we are very excited about getting the project off the ground, but we remain on schedule at this point. In terms of the all-in capital costs, in response to your question, does it include the electricity generation, yes, it does. This really takes care of our needs from a standpoint of becoming 100% self-sufficient on the coke-making front, and it's going to provide a substantial amount of the middle time works, energy needs and that's all in when we talked in terms of about, I think, $340 million, that kind of range.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

340 is the number that we've used.

Charles Bradford - Bradford Research

The coke... or the coking coal itself has clearly gone up a lot in price domestically at least on the spot basis over the last few months. What's your current situation? How longer the contracts that you have still go? And what are you looking for as far as next year?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Our deals by and large with coal suppliers are through the end of 2009. They do have some adjustment mechanism embedded in them as you might expect. And it will be really a joint process between ourselves and the Sun [ph] people in terms of buying them. Yeah, the agreements that we have just to make sure you're clear, we have caps on the escalators that are embedded in the agreements that expire in '09. As we've all seen, coal is a raw material that's in tight supply. We've seen the cost of that increase substantially. It's again why we have embarked on a program to incorporate that in our surcharge mechanisms, and we'll do everything we can to control that cost, and look at the various coal blends to bring the cost down. But over the long run that appears to be something that's going to be a cost challenge for everybody unless they have their own supply and we're going to take care of that when we get this project up and running.

Charles Bradford - Bradford Research

Well, thank you very much.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thank you.

Operator

Our next question comes from Bob Richard of Longbow Research.

Bob Richard - Longbow Research

Good morning, and thanks for taking our call.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Hi, Bob.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Good morning Bob.

Bob Richard - Longbow Research

The LIFO charge Al, over... a little overage there, was it pricing or volume, Al?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Well, it was largely pricing. We were controlling our volumes we think very well compared to where we expect to be at year-end, but it was a pricing impact.

Bob Richard - Longbow Research

So that kind of looked to me more towards raw materials than anything else. Can you maybe just qualitatively what were the largest contributors there?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Well again I think, just as I indicated, scrap clearly was an impact, obviously as well as natural gas. But it was really across the board.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Bob, I just emphasize the magnitude of that LIFO charge is really enormous at $82 a ton. In a constant kind of cost quarter, if you could imagine adding that to the 137 would have been closer to $200 plus a ton of operating profit, just to put that into perspective. And again at some point, I suppose in the future, our cost will level out, and we'll enjoy benefit of that. But in the near term, that's a cost that's been flowing through, and as Al mentioned, it will flow through again in the third quarter.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Bob, again just to be clear the... what we're talking about is what our expectation of prices will be at year-end, which clearly was largely scrap.

Bob Richard - Longbow Research

Right. And natural gas, you don't capitalize that out?

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Natural gas cost is reflected in your inventory value, and it flows through to your LIFO charge.

Bob Richard - Longbow Research

Roger. Thank you. And just a quick follow-up. The stainless volume is up sequentially 16%. That's good to see. Can you provide some color there or was that in line with your expectation?

James L. Wainscott - Chairman, President, and Chief Executive Officer

I think the stainless volume was above what we thought. We continued to set records in the electrical steel arena, which is part of what we disclosed as stainless as well. The commodity stainless business really is a function of the overall economy as much as anything. That's the 300 series 400 series is largely driven by automotive build and that's had its challenges but I think we've played through it very well. Again continuing to not produce anymore and put it into inventory but really makes the order ship at here in the US and increasingly offshore. But that's been a good business for us, I think it will continue to be.

Bob Richard - Longbow Research

Okay. Thanks for that color and great quarter, guys.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thank you.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Thank you, Bob.

Operator

Our next question comes from Michelle Applebaum of Michelle Applebaum Research.

Michelle Applebaum - Michelle Applebaum Research

Hi. Great quarter, great guidance, great to hear you. Could you give us a little bit more clarity on how your investment at Butler is going to help you in terms of your slab problems or slab opportunity or slab requirements?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Good to hear you too, Michelle. Thank you for the comments. Just to sort of step back for everybody to get on the same page, we did announce late last year that we were going to invest substantial dollars in a new number 5 EAF that would have the capability of producing about 1.5 million tonnes annually taking the place of two or three older [inaudible] less efficient productive electric arc furnaces. And in the process of that, not only is it going to make our required stainless steel and electrical steels at that location but it will also really take us from being a short in terms of our carbon slab procurement to being essentially in line with what our annual needs will be.

For example, in the year 2008, we will probably buy somewhere in the 500,000 tonnes to 600,000 tonnes of purchased carbon slabs in a market that increasingly is in tight supply and very costly, and again as we did enter the latter half of 2009 and into 2010, we should essentially be out of that market for all intention [ph] purposes because we will be able to make our own carbon slabs at the Butler Works. It is a huge important project for us in terms of improving our cost position and our self-sufficiency.

Michelle Applebaum - Michelle Applebaum Research

Okay. And yes, it is very exciting. And can you also give me some idea of quantification of the outage at the hot strip mill at Middletown this quarter and then I am going to want a little bit of an outlook on the magnitude and timing of electrical steel price increases for whenever?

James L. Wainscott - Chairman, President, and Chief Executive Officer

We typically take about a five-day outage, that's what it is. This year we took one, last year in the third quarter as well. We have one of the most productive hot strip mills as you know in the world.

Michelle Applebaum - Michelle Applebaum Research

It's amazing.

James L. Wainscott - Chairman, President, and Chief Executive Officer

And any given day, we might make this grow number out there, 20,000 tonnes. So you're talking about taking something in the magnitude of about 100,000 tonnes of hot band [ph] or further process material out of the system in the third quarter certainly helps explain one of the items that Al talked about earlier which is our third quarter shipments. We should be well-positioned, ready to rock 'n' roll as we head into the fourth quarter and continue to await any kind of a positive sentiment coming out of the automakers and the housing market to really ramp things back up. Sorry, your second question?

Michelle Applebaum - Michelle Applebaum Research

Electrical steel timing and magnitude of pricing, last time we tracked it was calendar year product, is it still the case and if so or if not, what's the pricing outlook on that product?

James L. Wainscott - Chairman, President, and Chief Executive Officer

The pricing outlook is robust. We have not really quantified the level of pricing and I think it's probably inappropriate to do so at this time because all of our deals are not done. We've obviously [inaudible] customer, we have foreign customers and we're in the midst of those discussions, I would say just to reiterate my prepared remarks that we are well on our way to completing that. We're not quite all the way down. Hopefully, we will be at the end of the third quarter we'll able to put some more color on that, one quarter from now during our conference call.

Michelle Applebaum - Michelle Applebaum Research

In this calendar year?

James L. Wainscott - Chairman, President, and Chief Executive Officer

It's all calendar year, for the most part probably 90 plus percent.

Michelle Applebaum - Michelle Applebaum Research

Would it be fair to say that the momentum going into this year is comparable for the momentum going into next year?

James L. Wainscott - Chairman, President, and Chief Executive Officer

I would say from a demand standpoint, it's every bit as strong as it's been. Obviously this is a product that not only meets the infrastructure needs, it also helps the world deal with global climate change and we like being right at the forefront of that.

Michelle Applebaum - Michelle Applebaum Research

So would the momentum then and the pricing be comparable?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Again, as you come off higher basis and as you roll through surcharges and you do any number of things, we're going to see substantially improved prices. I think that it's just still a little bit too early to give guidance with respect to percentage price increase.

Michelle Applebaum - Michelle Applebaum Research

Okay. But substantially improved to something. So thanks for that.

James L. Wainscott - Chairman, President, and Chief Executive Officer

You are welcome.

Operator

[Operator Instructions]. Our next question comes from Evan Kurtz of Morgan Stanley.

Evan Kurtz - Morgan Stanley

Hi. Good morning.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Hey, Evan.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Good morning, Evan.

Evan Kurtz - Morgan Stanley

Just a couple of questions. One on electrical steel, something you can remind us kind of what the portion of your production is of grain-oriented electrical steel versus kind of the lower value non-grain oriented steels? And how that's going to change with the announcement yesterday on the annealing improvement?

James L. Wainscott - Chairman, President, and Chief Executive Officer

I think when we have talked publicly we've talked --- north of...

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

335, going to 344 on the RGO and in the non-grain oriented business, another 100,000 tonnes.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Yes, one of the key factors, Evan in our announcement with respect to our $21 million ad on yesterday is the flexibility that it gives us and the ability to continue to move towards the higher end of the product scheme. I think one of our global competitors had announcement out recently maybe earlier today about increasing electrical steel products. And it's important to realize that there is obviously a sort of a low-end medium grade and a high end. And just as with carbon steels and stainless steels and the area of electrical steels, AK Steel gravitates to the very high end of the market. So this modification is add-on, if you will, to our fourth expansion. It really continues to move us more in that upward trajectory, the high end of the regular grain-oriented in what we call, proprietary TCH kind of product for us. It's an area that we have grown substantially in the last five years and we continue to look at how we can capitalize given our technological advantages and our capital and our knowledge in this area, how we can continue to grow this and capitalize on this as we go forward.

Evan Kurtz - Morgan Stanley

Great. That's helpful. And one another question on slabs, last quarter you gave us some great detail on how many slabs are used in the quarter and what you expected for the remainder of the year. So if you... hoping you could repeat that again, how many we will use this quarter and what we expect for the second half of the year?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Again, let me take a shot. In the second quarter, it was a bit unique because of our planned glass furnace outage at the Middletown Works. So we supplemented that outage and consumed somewhere in the range of about 280,000 tonnes of purchase slabs. It will be far less in the third quarter, a number in the range of about 40,000 or so. And again, as I mentioned in a prior question, we're on a path to buy and consume somewhere between half a million and 600,000 tonnes this year. And as we look out to 2009, it will likely be about half of that level.

Evan Kurtz - Morgan Stanley

Great, thank you so much. And great quarter.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thank you.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Thank you.

Operator

Our final question comes from Michael Gambardella of J.P. Morgan.

Michael Gambardella - J.P. Morgan

Yes, good morning. And congratulations on another good quarter.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thanks very much, Mike.

Albert E. Ferrara Jr. - Vice President, Finance and Chief Financial Officer

Good morning, Mike.

Michael Gambardella - J.P. Morgan

Good morning Al. A couple of questions. One, what percent of your contracts have some type of input cost pass through and then what percent of the contracts have a pass through for iron ore, met coal and coke which are the bigger cost component issues?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Well, I think, Mike, let me answer it this way. The times they are are changing. And I say that, not just to recall one of my favorite songs but to sort of put things in perspective as we came into the year 2008. Again with little bit more than half of our business of a contract variety, about 70% of those contracts had some form of variable pricing agreement. And the remainder did not but in those cases where there was no interest in that we obviously had to charge a higher price. It was, an either or type event. I think that's relevant in hindsight but going forward as I said all of our contract agreements will have variable pricing in them. In the past really none of them incorporated iron ore, in the future all of them will.

Michael Gambardella - J.P. Morgan

Okay. And on the currently I mean, do you have contracts that have pass-throughs for iron ore, met coal or coke?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Yes, and no. Then again, each of our deals is a little bit different. Some of them are tied to market pricing indices. Some of them have components on some of those items that you mentioned. So each is a little bit different, I would say that they are all kind of coming together to incorporate all of the major elements as we need them to because each of those things that you mentioned, and a host of others have been rising exponentially. And we need to cover that as we go forward and we will.

Michael Gambardella - J.P. Morgan

Okay. Last question, how do you plan to benefit if there is a strike at your two major competitors, US Steel, and Arcelor Mittal and about six weeks from now, considering that, on the 50% of your business that if contract there is... there is going to be no surcharge that you will put in so there is no price increase there and on the other 50% that's spot, you have already said a September price hike, and finally are you seeing any of your customers acting like they are kind of hedge buying on a strike with you?

James L. Wainscott - Chairman, President, and Chief Executive Officer

Well, first of all again we have some unsold tonnage for the quarter, we are essentially sold out for the month of July, we are well into August on certain products and into September on others. The order book is about were we would like it to be, all things considered. We always challenge ourselves in terms of inventory levels and I suppose we could eek out a bit more and there is always the opportunity to buy more slabs, albeit at very high prices. We are certainly hopeful that our competitors are successful in getting labor deals done, although I would argue that no one will get the kind of deal done that we did with all of our labor agreements in recent years and we love the flexibility that we have, it's another thing that positions AK Steel very, very well in this environment. So we hope that that's the case, we've certainly read with great interest what Leo and others have to say about being it their turn and so be it. Again longer term tried to be there to meet the needs of our customers, there may be some opportunity here this quarter. We will be opportunistic if it comes up. The other part of the question.

Michael Gambardella - J.P. Morgan

Are you seeing any of your customers like hedge buying against a strike at your competitors by increase in net purchases from you?

James L. Wainscott - Chairman, President, and Chief Executive Officer

It's a little early to say we haven't seen a whole lot of that but it wouldn't necessarily happen for probably another other few weeks. I think we'll all be watching with interest as we turn the calendar into the month of September.

Michael Gambardella - J.P. Morgan

All right, Jim. Thank you.

James L. Wainscott - Chairman, President, and Chief Executive Officer

Thank you very much. Well, let me just say to all of you as we sign on for another quarter, once again thank you for joining us on today's conference call. We understand that providing certainty in a rather uncertain world these days is a difficult thing to do but having said that, AK Steel has repeatedly done what it has set out to do, deliver great results quarter-after-quarter, year-after-year. And so despite the challenges that may lie ahead, we intend to deliver more record-breaking results in Q3 and for the full-year 2008 as we continue to position the company for future success. We have made great strides in becoming one of America's premier steel makers, we're certainly proud of our past but even more excited as we look out to the future and we hope you'll all join us again in October for a recap of our third quarter results and until then, we wish you a great day and a great summer.

Operator

Ladies and gentlemen, this concludes our conference call for today. Thank you for participating and you may disconnect at this time.

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Source: AK Steel Holding Corp. Q2 2008 Earnings Call Transcript
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